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Edited Transcript of ENOC earnings conference call or presentation 14-Mar-17 1:00pm GMT

Thomson Reuters StreetEvents

Q4 2016 EnerNOC Inc Earnings Call

BOSTON Mar 14, 2017 (Thomson StreetEvents) -- Edited Transcript of EnerNOC Inc earnings conference call or presentation Tuesday, March 14, 2017 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Sarah McAuley

EnerNOC, Inc. - VP Marketing

* Tim Healy

EnerNOC, Inc. - CEO, Chairman, Co-Founder

* David Brewster

EnerNOC, Inc. - President, Co-Founder

* Bill Sorenson

EnerNOC, Inc. - CFO

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Conference Call Participants

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* John Quealy

Canaccord Genuity - Analyst

* Pavel Molchanov

Raymond James & Associates, Inc. - Analyst

* Ben Kallo

Robert W. Baird & Company, Inc. - Analyst

* Sean Hannan

Needham & Company - Analyst

* Monika Garg

Pacific Crest Securities - Analyst

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Presentation

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Operator [1]

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Good morning, ladies and gentlemen, and welcome to EnerNOC's fourth-quarter 2016 conference call. My name is John and I will be your moderator for today's call. (Operator Instructions). As a reminder, ladies and gentlemen, this conference call is being recorded. I would now like to introduce your host for today's call, Ms. Sarah McAuley. Please go ahead.

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Sarah McAuley, EnerNOC, Inc. - VP Marketing [2]

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Thanks, John, and good morning, everyone. Welcome to our fourth-quarter and fiscal-year 2016 conference call. I'm joined on today's call by Tim Healy, our Chairman and CEO; David Brewster, our President; and Bill Sorenson, our Chief Financial Officer.

The press release announcing our fourth-quarter and fiscal-year 2016 results and the slide deck that we will reference during this morning's call as a supplement to our prepared remarks are available on the Investor Relations section of our website at investors.EnerNOC.com.

During this call, we will refer to non-GAAP financial measures, including adjusted EBITDA and free cash flow. These are non-GAAP financial measures that are not prepared in accordance with generally accepted accounting principles. The definitions and reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures are available in today's press release.

On today's call, we will discuss estimates, as well as make statements, that are forward looking under the Private Securities Litigation Reform Act of 1995 and other federal securities laws. These include, but are not limited to, management's future expectations, beliefs, intentions, goals, strategies, plans, prospects, and any other statements that are not historical fact. These statements are subject to risks and uncertainty and involve a number of factors that could cause actual results to differ materially from those expressed or implied. Additional information concerning these factors is contained in our filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q, available at www.SEC.gov.

The forward-looking statements made today represent our views as of March 14, 2017, and we disclaim any obligations to update them to reflect future events or circumstances.

With that, I'll turn the call over to Tim.

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Tim Healy, EnerNOC, Inc. - CEO, Chairman, Co-Founder [3]

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Thanks, Sarah, and good morning to everyone joining us on today's call.

I'd like to begin by highlighting the announcement we made in this morning's press release regarding our intentions to explore financial and strategic alternatives. Since the time of our IPO, our management team and Board has been focused on ensuring that we always are making proactive decisions to maximize long-term shareholder value. This focus has guided our actions as we have acquired and divested businesses, managed our balance sheet, and made choices around how we return capital to shareholders. To date, we made these decisions with a view towards maintaining our current corporate structure and positioning ourselves as a holistic energy management provider of choice, offering a complete suite of energy intelligence software, procurement, and demand response solutions to businesses around the world.

At the same time, we recognize that our businesses each have distinct financial characteristics and require different levels of investment in order to thrive, which complicate our equity story and make valuing our long-term prospects challenging.

We've therefore determined that it's in the best interest of our customers, employees, and shareholders to explore potential alternatives to our current structure. This may include the sale or separation of one or more of our business units, a sale of the Company, or other alternatives.

Conversely, the outcome of this process may be a proactive decision not to transact at this time. We've retained excellent financial and legal advisors and we are undertaking a process that is both rigorous and efficient. We do not intend to comment further on this until the process has reached its conclusion.

So with that, let me move on to a discussion of our fourth-quarter and full-your results. We are happy to report that we finished at or above the midpoint of our guidance for all of our major financial metrics. We achieved revenue of $404 million, minimized our EBITDA losses to negative $4 million, and ended the year with a healthy $98 million of cash on our balance sheet. Similar to previous quarters, our strong performance was driven primarily by the strength of our Demand Response business, which continues to drive healthy cash flow and exciting international and domestic growth opportunities.

In just a minute or two, I'm going to ask David to describe some recent developments in Taiwan, Japan, and in the US specifically. But in general, it's worth spending a few minutes to discuss the overall outlook for the Demand Response business as a whole. With the Supreme Court decision regarding FERC Order 745 now a full year behind us, the uncertainty that plagued the Demand Response market during the lead-up to that landmark decision is fully behind us and the industry globally is expected to enter a sustained period of growth.

Battery storage and other distributed energy resources are opening the doors to new forms of Demand Response. More and more wind and solar are coming onto the grid, requiring increased investments and balancing resources. And even in a changing political climate, Demand Response's future looks bright because it has long enjoyed bipartisan support. Unlike other forms of clean energy, Demand Response does not require government subsidies. It simply requires market access and an opportunity to compete with traditional generators. This is competitive markets doing exactly what competitive markets are supposed to do.

As we head into this next wave of Demand Response innovation, EnerNOC continues to execute against what it has always considered its unique strength -- using technology to connect businesses to energy markets, giving large commercial, institutional, and industrial customers a way to monetize and manage their flexibility, while providing a valuable resource to the grid.

Few energy technology companies have been able to solve the customer acquisition challenge, but this has always been one of EnerNOC's core strengths, and today we have over 8,000 valued customers. Those customers span the energy maturity lifecycle. For some, Demand Response is an easy first step to getting smarter about energy management. It requires no capital investment, and the credibility of the EnerNOC brand and our track record of success and our global footprint give our customers confidence that participating in Demand Response is a worthwhile proposition.

While Demand Response is a good first step, those customers who are further up the maturity curve have turned to EnerNOC for a complete solution that includes buying energy more strategically, incorporating renewable energy procurement strategies into their supply mix, accurately recording consumption for various sustainability protocols, and diligently managing energy to reduce costs and improve operational performance. We have worked hard over the past several years to build the most robust capabilities on the market to serve those mature customers, and the results our customers are getting are impressive.

We also see more ecosystem players coming to the table, eager to offer EnerNOC's CIS solutions. In the fourth quarter, we signed a strategic partnership with Brookfield Global Integrated Solutions, BGIS, a leading real estate management services company that manages approximately 300 million square feet of client portfolios across 30,000 locations globally. And in our first pilot engagement together, we delivered more than 25% in annualized savings to one of BGIS' premier retail banking customers.

Overall, we grew our subscription software revenue by 40% in 2016, after removing the revenues associated with a recently divested product line.

We continue to believe that this is a large untapped market opportunity and that our software solutions are particularly well positioned to capitalize as the market matures. We have experienced favorable indicators that the market is moving more steadily toward proactive energy management through EIS. In fact, in a recent study conducted by Grail Research, 43%, nearly half of respondents, said that EIS is extremely relevant to their business, up from just 10% the previous year.

Similarly, in the 2016 survey, seven out of 10 respondents indicated that they are likely to make an EIS purchase in the future. The increased awareness of EIS and the belief that software can be a competitive game changer for savvy enterprises is encouraging for the prospects of our software business.

That said, we do recognize that the early adopters of EIS represent a small portion of today's addressable market, that the rate of customer adoption has been slower than we had hoped and anticipated, and that our level of investment needs to be more aligned with the maturity of the market as a whole. We took some significant steps in that direction in the third quarter of last year with the restructuring of our software business, and we will continue to work diligently to ensure that our investments in our software segment are aligned with near and midterm adoption rates.

So, for now, I'd like to turn the call over to David to speak to some of the exciting developments and growth opportunities that we are pursuing today. David?

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David Brewster, EnerNOC, Inc. - President, Co-Founder [4]

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Thanks, Tim, and good morning to everyone joining us on the call. I'm excited to update you on some of the important growth opportunities that we are pursuing, new contracts that we have recently won, and a newly formed partnership that we've developed.

On the Demand Response side of the business, two achievements in particular stand out. First, we were awarded our first competitively tendered contract to deliver Demand Response capacity in Japan. This new 60-megawatt contract with Kyushu Electric Power Company is the beginning of what we believe is a key inflection point in the Japanese market. For the past few years, EnerNOC Japan, which is a joint venture between EnerNOC and Marubeni Corporation, has been participating in government-sponsored pilot projects. Time and again, EnerNOC Japan has stood out among participants as the entity that consistently delivers over and above expectations.

Japan's Demand Response market is still in its early days, but in the third largest economy in the world with a peak demand for electricity similar to that of the PJM market and a legislative mandate to move to a restructured competitive wholesale electricity market, we are optimistic about our growth potential there. We believe that our early track record in Japan and the local brand strength of our partner, Marubeni, puts us in a strong position to capitalize on the Japanese DR potential.

More recently, we announced that EnerNOC has expanded its Asian footprint with a 200-megawatt contract with Taiwan Power Company. We intend to deliver this full amount of capacity this summer, which demonstrates how quickly EnerNOC can mobilize and deliver Demand Response. This is our first Demand Response contract awarded in Taiwan, and under the terms of the agreement, EnerNOC Taiwan will be the exclusive Demand Response aggregator in Taiwan for the duration of this initial two-year contract.

As Korea has proven to be, we believe that Taiwan will be a great case study for Demand Response. With the system peak load roughly the size of Australia's, reserve margins in Taiwan have dipped to as low as 1.5% recently, which makes it challenging for Taiwan Power Company to reliably deliver power during periods of peak demand.

In less than one year, Taiwan Power Company issued an RFP, selected EnerNOC Taiwan, and will have a clean, cost-effective, and reliable 200-megawatt resource. This type of rapid response to a critical system need simply cannot be achieved by traditional supply-side solutions.

Like our presence in Japan, to go to market in the most capital-efficient manner and to quickly acquire customers, we have signed a joint venture agreement with an established market leader. Cheng Long Intelligent Engineering, or CLIE, is the leading Taiwanese energy services company, with more than 350 existing commercial and industrial customers.

Japan and Taiwan are indicative of the opportunity that we see ahead for expansion into large markets, and our decision to enter these markets with a trusted partner is a model that we believe is effective and repeatable, shortening our path to profitability in these new, exciting markets with high growth potential.

Here in the US, we continue to deepen our penetration in existing DR markets and create more value for our customers and our shareholders by capitalizing on new market opportunities. As a new announcement this morning, we have just signed a 30-megawatt, multimillion-dollar contract with PECO, which is Pennsylvania's largest utility. Similar to the contract that we announced back in January with FirstEnergy, under the terms of this contract EnerNOC will deliver Demand Response resources to help PECO cost-effectively meet its demand reduction targets.

This is just one example where EnerNOC can mobilize customers quickly and cost effectively to provide value to distribution utilities above and beyond the value that these customers provide to the wholesale market. And we're able to do so without our traditional customer acquisition costs, since we are bringing these new, layered Demand Response opportunities to our existing customers.

On the procurement side of the house, we have also made some exciting progress. We are now providing our energy sourcing and advisory services to customers looking to take advantage of the recently liberalized Mexican electricity market. One of EnerNOC's initial engagements in that region includes a procurement contract with a leading automotive systems and components supplier. Our initial go-to-market plan on this front is to offer services directly to our roster of US-based customers with facilities in Mexico. And given our deep relationships with industrial and manufacturing facilities, through both Demand Response and our software business, we feel this is an attractive market opportunity that we can serve in a cost-efficient and targeted manner.

We are also looking to expand our presence locally in Mexico by working directly with a few leading channel partners in the region, a model that has worked well for us domestically.

With that update on some exciting new growth opportunities for the Company, I'll turn the call over to Bill to review our key financial metrics. Bill?

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Bill Sorenson, EnerNOC, Inc. - CFO [5]

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Thank you, David, and good morning, everyone. My commentary will follow along with the slides that we posted to our website this morning.

On slide four, you will see that consolidated revenue for the year was $404 million, which is relatively consistent with revenues from the prior year and represents a 6% year-over-year increase when adjusting for revenues from divested business lines.

Although consolidated revenue was essentially flat, full-year consolidated adjusted EBITDA improved by $20 million year over year to negative $4 million. This improvement in adjusted EBITDA was due to a 150 basis-point improvement in gross margin to over 40%, as well as a reduction in operating expenses driven by restructuring actions and divestitures.

The year-over-year improvement in gross margin was driven by our Demand Response business, where we recognized high-margin incremental auction revenue and benefited from favorable portfolio effects. Excluding prior-year goodwill impairments, restructuring charges, and gains on sale of businesses, full-year operating expenses decreased by $26 million year over year, again primarily due to our restructuring actions and divestitures.

Diluted loss per share was $1.72 for the year, compared to $6.51 in the prior year. Relative to guidance, adjusted EBITDA and EPS came in higher, due principally to strong execution in our Demand Response segment and continued efforts to reduce our cost structure.

On slide five, you will find the results for our Demand Response business. Full-year Demand Response revenue was $337 million, comprised of $275 million from grid operator customers and $62 million from utility customers. This compares to prior-year Demand Response revenue of $318 million, comprised of $258 million from grid operator customers and $60 million from utility customers.

Although there were other moving pieces in the Demand Response business, the most meaningful year-over-year changes were in PJM and South Korea. PJM revenue increased by $18 million year over year, despite lower pricing, primarily due to our increased participation in the PJM extended program. And South Korea revenue increased by $13 million year over year, primarily due to an increase in enrolled megawatts.

These increases were partially offset by lower pricing and/or fewer enrolled megawatts in our Alberta and New England programs. Demand Response full-year adjusted EBITDA increased by $16 million to $68 million, primarily due to our increased participation in the PJM extended program, an increase in high-margin revenue associated with our participation in incremental auctions, and the improved management of our Demand Response portfolios.

Turning to slide six, our software segment revenue was $67 million for the year, down from $82 million in the prior year. However, the prior year includes the results of three businesses that we have subsequently divested. Removing the revenue of these operations from both 2015 and 2016 yields total organic software segment growth of 7% year over year, with organic subscription software revenue growth of 40%, driven largely by the success of our channel partnerships, notably Sun Power.

Software adjusted EBITDA improved by $5 million to negative $53.5 million for the year, due to lower operating expenses resulting from our restructuring actions, partially offset by lower gross profits from divested professional services business. As previously reported, the restructuring actions we took in both Q2 and Q3, which were concentrated on our subscription software and professional service businesses, are expected to reduce operating expenses on a full-year run rate basis by $35 million to $40 million in aggregate.

On slide seven, we show the quarterly trend of our subscription software metric. In Q4, both our subscription software ARR and our ARR per customer stayed flat to the previous quarter, at $28 million and $28,000, respectively. Both numbers are up modestly year over year, but the success we had adding new customers and expanding existing customers was largely offset by churning less profitable customers, in part as a result of our restructuring action. It's fair to say that we have a higher-quality customer base now than we did a year ago, engaged customers that are deriving meaningful value from our EIS. But our aggregate ARR has not meaningfully expanded.

Consolidated free cash flow for the year was negative $60 million, comprised of an operating cash outflow of $45 million and capital expenditures of $16 million. We ended the quarter with $98 million of cash on the balance sheet. In addition to one-time restructuring payments, operating cash flow was largely impacted by our participation in the 2015-2016 PJM extended program, in which we recognized all program revenues in the second quarter of 2016, but received over half of the corresponding cash payments in 2015. In the coming weeks, we intend to post to our website a more detailed representation of when EnerNOC recognizes revenue and collects cash payments from various PJM programs.

On slide eight, you will find an overview of our election to early adopt the ASC 606 revenue recognition standards in 2017. In summary, the new standard will allow us to recognize Demand Response revenues throughout the delivery months of the corresponding programs. This will lead to reduced revenue seasonality, in particular from our participation in PJM programs. Although we do not expect to recast historical financials for comparative purposes, we estimate that applying this standard would have resulted in roughly $60 million less PJM revenue recognized in 2016.

In addition, the new standard will accelerate recognition of our energy sourcing procurement solution revenues upon completion of the auction events in our platform versus recognition over the life of the contract. Despite this acceleration, annual revenues are expected to be negatively impacted, as we will not be able to recognize revenue from auctions closed in prior years under the new standard. We further anticipate the acceleration of revenues will generate some lumpiness, as quarterly revenues will be largely dependent on the size and timing of supply contracts procured.

It's important to note that the new standard will have no impact on the expected timing or magnitude of cash receipts for either our Demand Response or procurement solutions businesses. However, the new standard is expected to significantly increase the net assets at the procurement business. This, in turn, will result in a one-time goodwill impairment charge in Q1 of approximately $6 million or negative $0.20 per share.

Slide nine contains our full-year 2017 guidance, which does not include any potential impact of the strategic alternatives we are currently evaluating. Our initial full-year 2017 outlook includes $310 million to $340 million of consolidated revenue, with $260 million to $280 million for the Demand Response business and $50 million to $60 million for the software business.

Within the Demand Response business, we expect revenue from utilities to be relatively flat and we expect revenue from grid operators to be down 20% to 30% on a year-over-year basis, primarily due to our program mix in PJM. Recall that in 2016 we recognized revenues related to the 2015-2016 PJM extended program of approximately $75 million that had been deferred until the end of the program delivery period in May 2016. We did not participate in the 2016-2017 PJM extended program, so there are no such deferred revenues to recognize in 2017.

Within the software business, after adjusting for 2016 divested product lines, we expect subscription software and professional services revenue to remain relatively flat or modestly decrease due to our restructuring actions, through which we terminated certain unprofitable contracts. We expect our procurement solutions revenue to decrease by approximately 20%, primarily as a result of the adoption of ASC 606. As previously mentioned, procurement energy sourcing revenue recognition will more closely align to bookings.

Our full-year expectation for adjusted EBITDA is negative $20 million to negative $5 million on a consolidated basis, with $20 million to $30 million from the Demand Response business, between negative $20 million and negative $15 million from the software business, and approximately negative $20 million from unallocated corporate expenses. In 2017, we expect to benefit from changes in working capital in PJM, which will improve cash flow as compared to our adjusted EBITDA guidance. Full-year GAAP loss per diluted share is expected to range from $2.57 to $2.07.

Slide 10 highlights the first-quarter guidance included in the full-your guidance I just discussed. For the first quarter, we expect consolidated revenue in the range of $41 million to $47 million, comprised of $30 million to $34 million of Demand Response revenue and $11 million to $13 million of software revenue. Adjusted EBITDA is expected to be in the range of negative $23 million to negative $20 million and the GAAP loss per diluted share guidance range is negative $1.49 to a negative $1.39, which includes negative $0.20 per share of goodwill impairment, as discussed earlier.

I'd like to end with some comments about our current business priorities. We are excited about the growth prospects for our Demand Response business and we remain committed to driving cost efficiencies across both businesses and limiting the EBITDA losses of our software business. Similar to last year, cash preservation and expansion is a key consideration and will be foremost in all of our efforts.

As Tim stated earlier, the management team is confident that evaluating strategic alternatives is the best path forward for enhancing shareholder value and is critical to realizing the full potential of both our Demand Response and software assets. We look forward to providing more information on that evaluation at the appropriate time.

Tim?

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Tim Healy, EnerNOC, Inc. - CEO, Chairman, Co-Founder [6]

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Great. We will now open it up to questions from the folks on the call.

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Questions and Answers

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Operator [1]

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(Operator Instructions). John Quealy, Canaccord.

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John Quealy, Canaccord Genuity - Analyst [2]

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So, I guess two questions. First, just in terms of the review of the strategic alternatives, I guess the question -- and it sounds like anything is on the table. Just walk us through why now. We've seen software cadence sort of been lumpy, so just talk to us from your perspective, Founder, Board level, why is this the time to explore strategic alternatives?

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Tim Healy, EnerNOC, Inc. - CEO, Chairman, Co-Founder [3]

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I don't think it's anything more than what we said on the Board. This is the right time. It's the way that we can maximize shareholder value. We think that we have an equity story, as I mentioned in my remarks, that makes it difficult for investors to sift through some of the complexity of the business. I think we've described how the business continues to have levels of complexity that are outside of our control, in many respects.

And exploring strategic alternatives is certainly something that a lot of companies are doing these days and we think that it could provide us a number of options to continue to drive and make sure that we maximize the value of each one of the businesses that we have that we continue to be very excited and very bullish about the prospects for those businesses.

But we've indicated on many occasions that we are sitting in a really advantageous position with our customer base and it's time to figure out exactly how we make the most for shareholders out of what we have created to date. This May will be our 10th year being a public company. I think we've done what we set out to go and do, in many respects, which is to put ourselves in a position to really change the way the world uses energy, to put our customers in position to manage energy differently, and we want to continue to have those opportunities. It just may be that we need to look at different financial structures and different options in order to go do it.

So, now seems like the best time, and that's why we decided to announce it on today's call.

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John Quealy, Canaccord Genuity - Analyst [4]

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Okay, that's fair. And I can appreciate and respect you are just going to let that process play out and you will update us as needed. Just to follow on to that, so I imagine this process, we've seen it take shape at other companies. This is easily a six-, nine-, 12-month type of thing. Or how do you and the Board think about this?

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Tim Healy, EnerNOC, Inc. - CEO, Chairman, Co-Founder [5]

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Well, we are already in the process. We've hired advisors, legal and financial advisors, as we mentioned. We like what that process has started to uncover for us and we intend to do things very, very quickly here. And knowing that we are not starting from ground zero with today's announcement, I think we feel pretty optimistic that we will be able to come back to the market very shortly and let the market know how the process played out and what alternatives presented themselves and mainly what direction we are going.

I'm not sure that we share the same sentiment around it having to take six to nine months. I think we have a sentiment that it's a shorter process than that. And I'll leave it at that.

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John Quealy, Canaccord Genuity - Analyst [6]

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Okay. No, that's great. And then, just last for me, so congratulations on the stuff in Asia. That was a lot of hard work over a lot of years, so I congratulate you and the team. Maybe, David, can you talk about the margin profile there of the Asian business? Just remind us what sort of context that is for the gross margin. Thanks, guys.

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David Brewster, EnerNOC, Inc. - President, Co-Founder [7]

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Sure, John. So we -- as we've talked about, Korea has been a major success for us, where we've gone from a standing start to over a gigawatt of capacity, and now we have a good opportunity materializing in Japan and a great foothold in Taiwan, and then, obviously, our businesses that we have in Australia and New Zealand. So we feel really good about our position in Asia.

When you look at most of the industry experts that forecast growth of DR, a lot of the growth over the next five to 10 years is going to be in Asia. So we really like our position there.

The business model is the same, John, so there's no material difference in terms of margin profile. It depends on the customer mix that we go grab. In Korea and Taiwan, you have major industrial base, a lot of industrial customers, and so it allows us to grow very quickly. And we manage that with margins. We are very focused on, obviously, attracting customers at the best margins for EnerNOC and we will continue to focus on them, but not materially different from the rest of our portfolio.

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Operator [8]

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Pavel Molchanov, Raymond James.

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Pavel Molchanov, Raymond James & Associates, Inc. - Analyst [9]

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As I look at the guidance for 2017, it looks like both DR and software are down about 20% from last year's levels. But you refer to some of the accounting quirks that are adding some complications there. On a clean basis, if the accounting treatment of both segments were exactly the same as before, how much would revenue be down in 2017?

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Bill Sorenson, EnerNOC, Inc. - CFO [10]

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It would be down -- we would basically be moving as much as $100 million of revenue out of 2017.

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Pavel Molchanov, Raymond James & Associates, Inc. - Analyst [11]

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So -- sorry, to clarify, you mean it would be $100 million higher?

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Bill Sorenson, EnerNOC, Inc. - CFO [12]

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No. It would be $100 million less.

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Pavel Molchanov, Raymond James & Associates, Inc. - Analyst [13]

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$100 million less? Okay. In your comments about, I think it was, the procurement segment, you mentioned that there is a reduction in reported procurement solutions revenue in 2017 because of an accounting change. Did I catch that right?

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Bill Sorenson, EnerNOC, Inc. - CFO [14]

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Right, and that's right, Pavel. So when you look at the two businesses, revenue recognition impacts them differently. So for Demand Response, which is the majority, basically you have the acceleration of revenue to more accurately reflect when the revenues are being impacted or when we are effectively providing the service, which is previously, under 605, we had to wait until the final maturity of the contracts.

In the procurement world, what you have is effectively the contracts which previously we were able to recognize it ratably over time, because effectively the service is delivered, we have to recognize the revenue upfront at the time we conclude the auction. So, therefore, what you have is the revenue for procurement being recognized initially upfront versus what you have related to the Demand Response business being recognized ratably over time.

So in 2017, what happens with procurement is that basically we now have to take the historical revenues that had been previously contracted, move that through net income, and then recognize new auction revenue as it comes in. Under Demand Response, as we basically move into 2017, portions of what we deliver for 2017 and 2018 programs we are able to recognize during 2017.

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Pavel Molchanov, Raymond James & Associates, Inc. - Analyst [15]

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Okay, understood. And then, just a quick follow-up on the OpEx. You have obviously had some headcount reductions last year. Hence, we see SG&A and R&D expense coming down. Are those headcount reductions over or is there still more to come?

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David Brewster, EnerNOC, Inc. - President, Co-Founder [16]

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We basically announced the restructuring efforts that we put in place already. The impact of those are reflected within the guidance that we've given you.

We are continuing to basically look at all of our businesses to understand what is the most effective way for us to deliver all of the services that we basically deliver. So from that perspective, you can expect we're going to keep looking. But there's no additional restructuring that we have currently planned.

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Pavel Molchanov, Raymond James & Associates, Inc. - Analyst [17]

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All right. Appreciate it, guys.

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Operator [18]

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Ben Kallo, Robert W. Baird.

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Ben Kallo, Robert W. Baird & Company, Inc. - Analyst [19]

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When you look at the two businesses, how do you guys allocate capital at this point for growth and then considering the strategic alternative decision?

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Tim Healy, EnerNOC, Inc. - CEO, Chairman, Co-Founder [20]

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What we have done consistently throughout our history is we take a look at -- in our case, there's two lines of business when we talk about it in terms of our Demand Response business and our software business. When we think about our structure here at EnerNOC, we have three general managers. We have a general manager of our Demand Response business, the general manager of our subscription software business, and a general manager of our procurement solutions business that's in our software business.

And we ask those general managers to come to us in the fourth quarter of the prior year with their set of goals and objectives for the year and the required investment levels for their key initiatives. And we rank order those initiatives both at the general-manager level and then we rank order those on the overall corporate level.

We spend time as a management team. We do not have -- we look at the IRR that are projected from some of these initiatives. We look at that in terms of helping us with deciding where we're going to make investments. We trade off on near-term versus long-term investment outlooks for the various initiatives that are described. And then, we convene as a management team. We bring those to our Board of Directors. We describe the eight to 10 different opportunities that make the cut, and then we select a subset of those to go after.

What you heard this year was -- the things that are making the cut are the Demand Response opportunities that we see to invest in places like Taiwan and grow in those regions. The things that make the cut for our software business that you heard was the work that we want to do with channel partners like Brookfield Global because we think that those are cost effective and that they do things near term, right away, to try to drive profitability for our software business. And the things that you heard that we can do with our procurement solutions business have to do with exactly how we are investing in certain sales resources there because we think those sales resources have some near-term opportunities to drive a book of business and that there are things that we can do with channels in our procurement business that also have a very near-term focus on driving enhanced profitability this year and next year and putting us on a good path.

And then, we also look at things that make the list that don't require a tremendous amount of investment to get us excited as well. And I think we described a few of those, but I'll just highlight them. Our activity in Mexico with our procurement business was an initiative that we could support that had very little, almost no, incremental cost to us. There were really nothing that we needed to do to establish any sort of a physical presence in Mexico. We could take advantage of our current existing US customer base that had facilities in Mexico. And we could leverage some of our existing procurement team resources and our technology platform and our advisory activity to bring some of our customers into Mexico and drive profitability in a new region. So that's a way of expanding.

The things that you look at in our Demand Response business, where we've described some of the things that David talked about with the state of Pennsylvania and some of the contracts that we've signed there. What we are able to do is drive increased opportunity in year without having to go out and hire new resources and do a lot more investment in order to drive that. So that's some of the most cost-effective things we can do is go layer on top of existing customers in the PJM market utility-level programs like David described with the Pennsylvania utility, so that we can drive more value for those without incurring additional cost.

And those are the things that we try to do to look at where are our initiatives, where are we going to spend time, where are we going to focus, and then, as I described, rank order across the three different business units what the most attractive near-term opportunities are for making investments and growing those businesses.

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Ben Kallo, Robert W. Baird & Company, Inc. - Analyst [21]

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Great, thank you. And then one more, if I can. On the software side, what would you say has been the biggest headwind for growth? Is it product, people, or the market not being ready, I guess, or understanding that it takes longer than you originally had thought when you guys set out on this path?

And then over that time frame, how has the competitive market changed? Is it still a nascent market and you guys are number one? Or are there other people out there that you are competing heavily with? Could you just give us some color there? Thank you, guys.

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Tim Healy, EnerNOC, Inc. - CEO, Chairman, Co-Founder [22]

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So I think there's -- the challenges that we've seen in part have to do with the way customers have looked at energy management solutions in the past and the way that some of the early adopters and savvy customers are looking at it now, and matching up and aligning customer readiness with their actual reality.

And all I mean by that is that there are a lot of customers who in the past have been trained to expect outcomes, energy outcomes, from their service providers. And the savvy customers, the early adopters have really thought about their organization more holistically, and they have thought that they are looking for providers to provide them tools and solutions that they can leverage so that they can actually transform their business.

And what we've found is that there are customers that talk about that and then there are customers that are ready and aligned to do that. So one of the things that we've done this year is we've set up a process, and we started doing it late last year, in the fourth quarter of last year and into this year, we've set up a process to have a customer undergo an up-and-down, top-to-bottom assessment of their organization.

And what that is is in part it's making sure that the customer readiness is where we need it to be so that when we sell them something, they are not going to sit there and get stuck at a very small deployment, but that they are going to actually buy our software and integrate our software up and down and throughout the organization with C-level buy-in, with broad support across the customer base, with a program team that's going to act like other things that they do inside of their organization. When they buy software from vendors, they usually have an implementation team, a program team, and a team that's going to make sure that that organization gets the most value from the investment that they are making.

So with our industrial assessment program in the industrial vertical, I think we've started to tackle some of that mismatch in customer readiness. We've been able to identify customers that are looking for outcomes, outcomes that force us to drive a lot of the value for customers, to drive up the expense of servicing those customers because we suddenly have to add a lot more services to the mix than we were expecting. And we have been able to service more customers, sell more product to customers that have a higher level of organizational readiness.

We are doing it with industrial assessments. We are doing it in the commercial real estate sector through a similar discovery process. So we really narrow the focus, narrow the lens of who we are selling to so that we are not selling to customers that, six months later, turn around to be nothing more than a lot of hope and a lot of hype and not a lot of success and certainly not a lot of repeat business or profitability.

And I think we've gotten better at it. I'm very optimistic that the narrowing of the focus to the two verticals that we described, the commercial real estate vertical and the industrial vertical, is a step that we needed to make and we've made. We've reduced the amount of cost to sell. We've reduced the amount of effort. This is not a product and not a people issue. I think it's a customer adoption issue and really getting laser focused on making sure that we are aligning the expenses with where the market is today.

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Ben Kallo, Robert W. Baird & Company, Inc. - Analyst [23]

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Thanks, guys.

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Operator [24]

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Sean Hannan, Needham & Company.

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Sean Hannan, Needham & Company - Analyst [25]

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Just as a side note, good luck with the storm today. I just want to understand some components of the guidance a little bit more, specifically as I look into the grid operator business, so we know that there are some expectations for pricing in PJM to be down, where you have been building momentum in international and Asia. This has been referenced, obviously, through the call. Can you help us to better understand how that moves year on year?

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David Brewster, EnerNOC, Inc. - President, Co-Founder [26]

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I'm not sure I understand your question. How what moves, exactly?

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Sean Hannan, Needham & Company - Analyst [27]

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The international side.

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David Brewster, EnerNOC, Inc. - President, Co-Founder [28]

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Yes. Well, as we talked about, we are pretty excited about the growth opportunity for Demand Response globally. We've seen -- as Tim mentioned, we are a year behind the Supreme Court case. And the Supreme Court case, I think, put the world on hold until that was resolved. That was resolved a year ago and we've seen tremendous momentum.

We, as I talked about, have grown our Korean business to contribute over $35 million of projected revenue this year, into 2017. This 200-megawatt contract in Taiwan and 60 megawatts in Japan, those should contribute $5 million to $10 million of revenue in 2017 and could approach $20 million in 2018.

And what we are doing is building off our pipeline of countries around the world. We are being very selective. We are interested in large markets where there is a need for capacity, where we can get a first-mover advantage and, in many cases, where we can find a good, strong, local partner to go to market with to gain that first -- really capitalize on that first-mover advantage.

So we are excited about it. We have five-year plans that have us continuing to grow internationally. So, we are excited about our prospects and our position. We really do have the premier brands for Demand Response globally and are excited to get in early and help educate regulators and utility executives to design effective programs that be the first one to hit the ground running.

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Sean Hannan, Needham & Company - Analyst [29]

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Okay. So I guess what I'm trying to pull out, if we have some guidance in the grid operators in the aggregate being down 20% to 30% (multiple speakers) that's domestic and international, right? So should we interpret this as domestically we are down about 30% to 40%; international then provides that piece of the offset that brings us back into the guidance range?

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David Brewster, EnerNOC, Inc. - President, Co-Founder [30]

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Can you repeat the questions?

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Sean Hannan, Needham & Company - Analyst [31]

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Yes. I'm sorry, am I breaking up?

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David Brewster, EnerNOC, Inc. - President, Co-Founder [32]

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No, not at all. No, I just want to make sure I'm deciphering between what you're asking on international versus what you are asking on domestic. Domestic will indeed be down.

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Sean Hannan, Needham & Company - Analyst [33]

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Yes, exactly. So in aggregate, if we are looking at grid operators down 20% to 30%, domestic is going to be a number higher than that, right? So that would be -- so I'm trying to understand, is that something closer to a 30% to 40% domestically? And then, the offset from international brings us back into that range? Maybe that offset is in the 10% to 20% in their piece of the equation.

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Bill Sorenson, EnerNOC, Inc. - CFO [34]

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Yes. I wouldn't read too much into the 2017 domestic grid operator being down. It is entirely due to program mix in PJM. As I think we talked about, in 2016 we recognized $75 million of revenue related to the prior year, the extended program that we recognized revenue in 2016. And we don't have any of that extended program revenue coming in 2017.

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Sean Hannan, Needham & Company - Analyst [35]

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Understood.

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Bill Sorenson, EnerNOC, Inc. - CFO [36]

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And despite the lower revenue and EBITDA, we expect net cash flows from PJM to actually improve in 2017 versus 2016. So I wouldn't read too much into the revenue in domestic grid operators.

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Sean Hannan, Needham & Company - Analyst [37]

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Yes, I wasn't trying to read too much into it. Okay, that's fine. We'll move on.

So on the software side, though, similarly looking into the guidance now for subscription, now you've trimmed out some revenues and contracts. You are going to be flat year on year. What's that implying in terms of an inherent growth rate within the subscription at this point now?

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Bill Sorenson, EnerNOC, Inc. - CFO [38]

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We are basically looking at sort of flat numbers for the year. That's what you are seeing in there because what you had in the prior year is going to be the impact of businesses that we divested. It's also going to be the impact of customers that we basically churned out, because part of the analysis around improving the EBITDA was looking at a line-by-line delivery in terms of the product mix. And in several cases, what we found is we weren't making an adequate return relative to the service we delivered.

So what we've done is we've gone in and pared back customers that were not profitable to focus on those that are more profitable, the same approach we are adopting in terms of going to market, much more targeted in terms of the segments we're going after, in terms of commercial real estate and industrial, as opposed to a much broader aim in terms of software. So, more targeted businesses divested and basically reducing our unprofitable customers leads us to a flat outlook year over year.

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Sean Hannan, Needham & Company - Analyst [39]

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Yes. I guess I'll have to take this off-line because if I interpret that you have trimmed customers and contracts, right, and we are going to be flat year on year, there is some business coming from somewhere else, so I'm trying to understand what's the assumed growth rate. But that's fine. We can take it off-line. Okay. All right. Thanks very much for taking my questions here.

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Operator [40]

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Monika Garg, Pacific Crest Securities.

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Monika Garg, Pacific Crest Securities - Analyst [41]

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I have a question on the EBITDA guidance for Demand Response in 2017. I thought that pricing was actually supposed to be better for PJM in 2017-2018. But your DR EBITDA guidance is lower year over year. Could you maybe walk through that?

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Tim Healy, EnerNOC, Inc. - CEO, Chairman, Co-Founder [42]

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The issue here, Monika, is basically looking at the total amount of revenue that you are forecasting for DR into 2017. As David said a moment ago, in 2016 we had the benefit of summer and extended programs. We don't have as much as we go into 2017 and 2018 in terms of all the programs that we have. So the program mix definitely changes. So your EBITDA is going to be lower by a function of the lower revenues.

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Monika Garg, Pacific Crest Securities - Analyst [43]

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What is your free cash flow assumptions for 2017?

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Tim Healy, EnerNOC, Inc. - CEO, Chairman, Co-Founder [44]

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We basically have provided just what our EBITDA guidance is. And on a combined basis, our guidance is negative $5 million to negative $20 million for the consolidated businesses.

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Monika Garg, Pacific Crest Securities - Analyst [45]

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Because now revenue is also recognized in line how cash is coming in, so EBITDA and cash are very much aligned, which was not the case previously, correct?

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Tim Healy, EnerNOC, Inc. - CEO, Chairman, Co-Founder [46]

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No, that's not correct. The cash relative to -- the cash collections relative to the business is not impacted by what's happening with revenue recognition. But what has happened in the past with cash is when you do have difference in pricing between two program years. But, basically, we are expecting that the cash that comes in from the underlying contracts is not changing by virtue of the revenue recognition.

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Monika Garg, Pacific Crest Securities - Analyst [47]

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Okay, got it. The last one, on the software business your ARR has been flattish last some quarters. How do you see this business going forward? The flattish kind of a business you want to maintain, you see growth in that?

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Tim Healy, EnerNOC, Inc. - CEO, Chairman, Co-Founder [48]

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No. What we've set out to do is we've got a sales team that's going after two verticals we think we can grow. We can grow very healthy in the commercial real estate vertical, the industrial vertical. In peeling back what Bill has described is that in the software part of our business, we have a number of dynamics that are affecting how to look at that growth rate. When you peel it back -- just like last year, when you peel it back and you look at what we had, we had 40% subscription software growth.

This year we've gone in, and at the end of last year, the beginning of last year, we went back to certain customers and we proactively decided that we would end those contracts early, in some cases, before the end of the term of those subscription software agreements. We went back to the customers at the end of the agreements and said we are not interested in renewing those contracts with you because we were not finding that those were profitable customers to serve and we did not believe that there was a path forward with those customers that would turn them into the right long-term customer opportunities for us.

When you look at what we are doing this year, we have a team that has set out to grow the amount of subscription software revenues overall when you start to account for some of the things that Bill has described. So we do have growth in our subscription software business again this year when you peel back what our starting point is and look at what we expect to end the year at, and account for other churn we will do throughout the year as well.

When you look at the divestment of certain businesses, when you look at what we've done inside of the subscription software business, and then when you look at what is happening to the revenue recognition treatment for the procurement solutions business, then it becomes a more muddled story in terms of being able to see on the surface is there growth happening or is there not growth happening. We expect there to be growth when you account for the machinations that Bill tried to describe.

If you go back to the opening statement that I made, I think this is illustrative of the complexity of this story in light of the dynamics that are hitting the business at pretty much the same time. We've got revenue recognition that happens different -- a revenue recognition change for one business makes that business more ratable in the way we recognize revenue. That business, however, the Demand Response business, has program mix changes and pricing changes over the next several years that make that a muddled story to understand and to see the long-term effect of how that ratability of revenue recognition under a 606 rev rec policy will actually make that a more steady revenue recognition business over time. But there are some ups and down mixes to it that happen in the next several years that make that challenging and complex.

Conversely, the procurement business has the opposite effect. It makes a business that was already recognizing revenue ratably, makes that business more lumpy, as Bill described. And some of that lumpiness is what's mixing in and making it difficult to see some of the growth that's happening in the overall software segment.

So I understand the frustration. We are going to try to describe this through increased effort and work with our public shareholders. And, obviously, we are looking at strategic alternatives, as we described in the earlier part of the call, in part because of the reality that you are pointing out in some of the questions that you are asking us today.

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Bill Sorenson, EnerNOC, Inc. - CFO [49]

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And one of the things just to add, Monika, I think it's pretty important. To go back to your cash flow question, when you look at the guidance that we provided back at Analyst Day in 2016, we were pointing to the Demand Response business generating between $20 million to $25 million of cash flow in 2017 and $35 million to $40 million going into 2018. We do not expect that to change. So revenue recognition, to Tim's point, is complicating, but it's not changing the underlying cash flow dynamics of the business.

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Monika Garg, Pacific Crest Securities - Analyst [50]

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Thank you so much.

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Tim Healy, EnerNOC, Inc. - CEO, Chairman, Co-Founder [51]

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So I appreciate everyone's participation in today's call and we look forward to updating you as the situation unfolds and we have more news to report. Thank you all. Bye now.

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Operator [52]

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Ladies and gentlemen, that does conclude your conference. You may now disconnect.